Getting Started with Options Jump start your portfolio by learning options OptionsElitePicks.com
Your First Options Trade Let s walk through a simple options trade. For this walk through, I m going to use TD Ameritrade. STEP 1 Let s go to the quote page for the stock we wish to purchase options on. You will see a link to View Option Chain. You would click that to see the choices for an options trade on the stock we have chosen (in this example it s AAPL). STEP 2 You will then be shown the Options Chain for AAPL. These are usually grouped in 3 main ways. Whether it's a call or put option, by expiration and by whether the options strike price is currently in the money or out of the money. Let s look at what these terms mean. What are calls and puts? You would purchase a call option if you believe the underlying stock is going to go up in price and you would purchase a put option if you believe the underlying stock would go down in price. One friend of mine says put it down and call it up. What is an options expiration date? The option contract s expiration date refers to final day that the options contract is valid. When an investor buys an option, the contract gives them the right but not the obligation to buy or sell an asset at a predetermined price, called a strike price, within a given time period, which is on or before the expiration date. Page 2 of 10
Expiration dates are grouped into Weekly, Monthly and Quarterly. Not all stocks offer all three of these expiration types. Monthly expiration dates are the most common. What is a strike price? When I trade options, I view the strike price as the price that I m betting the stock will reach before the expiration date. Therefore, if I believe AAPL will be at or above 530 on or before November 29th 2013, then I d purchase a 530 call option with a Nov 29th expiration (this would be a call and not a put because I believe the price will increase). Here s the technical definition of strike price The price at which a specific derivative contract can be exercised. Strike prices is mostly used to describe stock and index options, in which strike prices are fixed in the contract. For call options, the strike price is where the security can be bought (up to the expiration date), while for put options the strike price is the price at which shares can be sold. What does in-the-money and out-of-the-money mean? This is a simple one. A call option is in-the-money if the strike price is at or below the stock s current market price and the call option is out-of-the-money if the strike price is above the stock s current market price. A put option is in-the-money if the strike price is above the stock s current market price and the put option is out-ofthe-money if the strike price at or below the stock s current market price. In the options chain screenshot below you ll see the in-the-money trades are highlighted. Now, let s continue with this example options trade with AAPL. Let s say we believe the price of AAPL will be at or above 520 by the end of the day on Nov 29, 2013. If this case, we going to buy a call option. Therefore we are betting that the price of AAPL will increase from its currently price of $524.72 (its Last price in the screenshot below). This is a safer bet than a 525 call, because the trade is already in-the-money at the time of opening it. It s a little less risk, little less reward. We would buy a 520 call option (the orange ns icons mean not standard, we ll ignore them for now.). The 520 call option that expires on Nov 29th is priced at a BID of $6.00 and an ASK of $6.15. Since we are looking to buy this option, for simplicity sake we would pay the ASK. (You could enter a BID at wait to be filled, but that s a whole other tutorial). Within TD Ameritrade, you could click the blue arrow next to where it says 520.0 Call > and select Buy. Now, let s continue on to choosing how many contracts. Page 3 of 10
STEP 3 Let s now enter the order details. For this example, you would choose to Buy to open on 10 contracts on AAPL (Weekly) Nov 29 2013 520 Call with a LIMIT order (mean buy at or below the price I enter) of $6.15, Timein-force: Day (this just mean that the if the order doesn t fill before market close, it ll auto-cancel). Then, you d click Review Order You would then be shown the details of the order you are about to place. Since we are looking to purchase 10 contracts at a price of $6.15, the price would be 10 contracts * 100 (each contract=100 shares of stock) * $6.15 = $6,150. Then, to finalize the order you would click Place Order. Page 4 of 10
STEP 4 The next step would be selling the options contract that we purchased. Hopefully, since we purchased a call option, the underlying stock has gone up in price. In this example, AAPL has increased in price since purchasing our Nov 29 520 Call. It s now priced at a $7.00 BID and a $7.25 ASK. Therefore, we could take some nice profits here and likely be filled at the bid price of $7.00. Let s enter that we wish to Sell to Close our 10 contracts at a Limit price of $7.00 and click Review Order. You ll see on the review order screen that the selling price of this example trade is $7,000, that would be an $850.00 gain, or about a 14% gain. You did it! You just made your first options trade! That wasn t that hard was it? You can go here to setup a practice account on TD Ameritrade. Page 5 of 10
Options Trading Risks vs. Stock Trading Risks A basic rule of thumb with options trading, is play what you are willing to lose. As opposed to stock trading where you might be willing to lose 4-6% of your investment per trade. Does this mean that options are too dangerous and risky to trade? No. They just have to be approached in a certain way to be properly utilized. I personally see options trading and a better way to manage risk and maximize your portfolio s gains. Let s look at a example of an Options Trade vs. a Stock Trade. In this example, we will have 2 people trading the same stock. One will buy the stock itself and the other will use call options. The sample stock is XYZ trading at a price of $30/share. Jim Stocktrader buys 1000 shares of XYZ, which costs him $30,000. Joe Optionsguy buys 10 contracts of XYZ, which exposes him to the same amount of shares. (Each contract controls 100 shares) The price per contract is $1.00. So, Joe s investment cost is $1,000. (Therefore, he s putting $29,000 LESS at risk than Jim Stocktrader) The most Jim Stocktrader can lose on this trade is $30,000. The most Joe Optionsguy can lose trade is $1,000. SCENARIO 1: Stock Goes Up +$10 If the stock went up in price before the expiration of the contract, this would of course, be a win for both traders. However, let s take a look at the numbers. Jim Stocktrader risked $30,000 and made $10,000 a percentage gain of +33.3% Joe Optionsguy risked only $1,000 and made $9,000 a percentage gain of +900%! A great win for both, but the options guy put much less at risk and had almost the same gain. That s a big win for options traders. Page 6 of 10
SCENARIO 2: Stock Goes Down -$10 If the stock goes down in price before the expiration of the contract, this would be a loss for both traders. Let s take a look at the numbers. Jim Stocktrader risked $30,000 and lost $10,000 a percentage gain of -33.3% Joe Optionsguy risked only $1,000 and lost $1,000 a percentage loss of -100% Having only risked $1,000. Joe Optionsguy shows the power of options trading once again. While the -100% looks scary, Joe Optionsguy played it right and walked away only losing -$1,000 compared to Jim Stocktrader who lost 10 times as much (-$10,000)! You can see from the way this played out, when traded properly, options trading can give you the opportunity for very large gains, while protecting you from large losses. Overview of a Call Option A call option is a contract that gives the buyer/owner of the option the right to purchase a stock, commodity, securities, bonds and other instruments at a specified amount within the specified period of time. Thus, if you bought an option, the call option gives you the right to buy the asset but you are under no obligation to purchase it should you decide not exercise the option. So supposing that the price of the underlying asset increases and becomes greater than the strike price, then you can profit by calling in your rights. The strike price is the price of the underlying asset as indicated in the option. For example, if you have the call option for a particular stock and the price of the stock suddenly increase and becomes greater than the strike price, this gives you the opportunity to buy the stock at a significantly lower price. The seller will have to sell the stock to you even if the market price of the stock is higher. You can then make money by purchasing the stock at lower price and then selling it at its market price. Investors purchase call options in the hope that the price of the underlying asset will increase and will be greater than the strike price in the option. Should this happen, the buyer then can buy and then sell the asset and make money from the transaction. On the other hand, if the price of the stock does not increase, the buyer may choose not to buy the asset. If the price of the asset remains lower than the strike price, the buyer will simply let the option to expire. On the other hand, sellers sell call options to profit from the premium. That will be the extent of their profit from the deal. Even if the price of the stock surpasses the strike price, this will not affect his earnings. Buying call options is significantly cheaper than buying stocks and other instruments. This is because the transaction in the call options is only for the buying and selling of the option. It does not involve the actual buying or selling of the physical property or the financial asset. In other words, when buying a call option for stock, you Page 7 of 10
are not buying the actual stock or share. You are only buying the option to purchase the stock should you decide to do so. This is one of the reasons why many invest in options instead of the actual stocks or commodities. The principle behind call options is very simple, For example, if you have found a car that you intend to buy but has no money to pay for it yet but will have the money in two months, you can enter into an agreement with the seller. You can ask him to hold the car for you for two months and you will pay for it at an agreed price. In turn, you will pay him a $3000 for the option to buy. In that two month period you can then purchase the car if you want and at the price stated in your agreement. Now, if you have suddenly found another car that you think is better, you can then simply let the option expire since you are under no obligation to purchase the car. However, you have then lost the $3000 you have spent on your option to buy. The same principle applies in call options. Investors make money from call options by buying the asset when the price increases and becomes greater than the strike price. If the price of the asset remains the same or remains lower than the strike price, options traders have ways to exit the option without losing money. They can offset the options through different offsetting strategies. These are the various ways to minimize the risk. So if you are interested in options trading, one of the most important things to learn is how to exit options position. There are many sites that will teach you how to exit with profit or without financial loss. In short, a call option or call is therefore a contract between the buyer and the seller of the option. The buyer has the right to purchase the asset from the seller at strike price and before the expiration date. The seller is obligated to sell the asset to the buyer should the buyer decides to exercise his option. The opposite of the call option is the put option. Put option is a contract between the buyer and seller of option, but in this case, the buyer of the put has the right to resell the asset at a specified strike price by the specified future date. The seller of the put then has the obligation to repurchase the asset at the specified strike price should the buyer decides to resell or exercise his put option. Overview of a Put Option A put option is a contract between the buyer and the seller of the put option. As a contract, it gives the owner or buyer of the put the right to sell an underlying asset to the seller at strike price or specified amount within the specified time. Put options is the opposite of the call option which gives the buyer the right to buy an underlying asset at strike price and within a specific period of time. The value of the put option is relative to the price of the underlying asset and the strike price. For example, if the price of the underlying asset decreases and becomes lower than the strike price, the buyer of the put can then exercise his right to sell the said asset at strike price. The seller, who is under an obligation to repurchase the underlying asset, will have no choice but to purchase the asset at strike price. This will give the buyer the chance to minimize the risk in this particular investment or option. The most common type of put options is stocks. However, other instruments and commodities are also traded on put options. Since the put options is a contract with defined time for the holder to exercise the option, if you are interested in trading in options, you should know that under the European put options, the buyer of the put Page 8 of 10
option is allowed to exercise his option only for a specified period of time before the expiration date. Under the American put option however, the buyer of the put option is allowed to exercise his option anytime before the put option expires. Buyers of put options believe that the price of the asset will drop before the expiration date. The option gives them the chance to protect their position by being able to sell it and by being able to sell it at specific price. The seller on the other hand believes that the price of the asset will rise. He will therefore make money from the premium. Should the price drop however, the buyer may exercise his right and he will have to purchase the asset. The risk therefore is greater for the seller. For the seller, his potential loss is equivalent to the strike price of the asset. A put that is purchased is called long put while put that is sold is called short put. There is a big difference between put options and short selling. Both are bearish strategies that are commonly used to hedge risks. Short selling is different from put options because short selling is the sale of an asset that is not owned by the seller. The asset is borrowed and then sold by the seller. The seller therefore has short position, hence it is called short selling. Supposing the stock drops as expected, the seller or the short seller will then buy back the stock at the lower price, thereby making a profit from the difference. Another difference between the two is that short selling poses greater risk than put options. This is because in put options, investors will only lose the premium paid for the option. In stocks, put options is used by an investor if he thinks that the price of the stock will drop. He will then pay for the premium which gives him the right to sell the stock once the price of the stock reaches the stock price or below the stock price. This limits his investment risk. For the seller, if the buyer does not resell the stock, his profit will be the premium paid by the buyer. Many investors use puts to protect profit and limit the risk in a stock. In buying a put, you have to remember that you will make profit if the market drops. Many investors also use the married put or protective put to cover an invested stock. The put is used therefore as insurance. In this case, the investor buys both stock and put options. The put option protects the investor if the price of the stock drops. If the price of the stock remains above the stock price and the option is not exercised, the investor would then lose nothing more than the premium for the put. The good thing about put options is that you can buy it without hefty margin requirement. Moreover, the risk is limited to the premium you paid for the option. At the same time, put options can also be sold for profit. As discussed above, sellers earn from the premium if the option expires. Thus, if you are interested in trading put options, you can both buy and sell puts. You have to remember however that selling puts is riskier than buying puts. Nevertheless, selling puts can also be as profitable once you know the various strategies in selling them. Page 9 of 10
Conclusion Are you ready to take your knowledge of options trading to the next level? We have many hours of educational material and live chat support from options trading veterans, just waiting to make you a success at options trading. When you're ready to start winning with options go to... https://www.optionselitepicks.com/member/signup/index Page 10 of 10